This post builds upon an idea presented in Part 4 of current series of posts on considerations for investment funds and advisers related to cryptocurrency derivatives.

In particular, this post provides additional perspectives on the relationship of leverage, margin, and financing to two commodity interests: “retail commodity transactions” and a “swaps”. We decided to present these comments separate from the current multi-part series on cryptocurrency derivatives, since the topic may appeal to a broader audience than funds and advisers.

This post was co-authored with Michael Selig, an associate attorney in the New York office of Perkins Coie.

As background, the CEA and, by extension, the CFTC substantively regulate transactions that involve “commodity interests,” a term defined by law to include “swaps” and “retail commodity transactions”.

Swaps: What They Are

The definition of a swap under section 1a(47) of the CEA is very broad, since any “agreement, contract or transaction” could be a swap if it:

• Requires a payment or delivery to be made by one party to the arrangement based upon the change in the value of an asset without conveying a direct or indirect ownership interest in that asset;
• Is an option of any kind on any asset other than a security; or
• Requires that a payment or delivery be made based upon the occurrence, non-occurrence or the extent of the occurrence of an event with a potential, financial, economic, or commercial consequence.

The current iteration of the term swap was added to the CEA in 2010, as part of the Dodd-Frank Act’s overhaul to the U.S. financial markets. Section 2(e) of the CEA makes it unlawful for a non-ECP to enter into a swap, unless it is entered into over a futures exchange

Retail Commodity Transactions: What They Are

Section 2(c)(2)(D) of the CEA defines a retail commodity transaction as an agreement, contract or transaction that is offered or entered into by a party:

• On a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis; and
• To or with persons who do not qualify as an ECP (or a sub-category of ECP known as an “eligible commercial entity,” the discussion of which is beyond the scope of this posting).

If both parties to a transaction are ECPs, then the transaction is NOT a retail commodity transaction (although, depending upon facts and circumstances, that transaction may constitute a swap). If one of the parties to the transaction is not an ECP and the transaction involves leverage, margin or financing, then this category of commodity interest is likely to be relevant or, at a minimum, should be analyzed to determine whether it is relevant.

Swaps and Retail Commodity Transactions: What Are They?

If you have an interest in commodity interests, then these are interesting times or at least times worthy of more than a passing interest.

Why? Because we have recently learned that the CFTC views certain transactions, historically treated as swaps, as retail commodity transactions. Or, put differently, we have learned that the CFTC appears to view “swaps” and “retail commodity transactions” as overlapping in the Venn diagram of commodity interests, at least with respect to a contract for differences (or “CFDs”), as further explained.

How? Because of “leverage or margin,” but not necessarily financing…

The concepts of “leverage, margin, and financing” are not well-developed for purposes of the retail commodity transaction definition or the CEA more generally.

It would seem that a transaction that involves the use of borrowed funds or property to purchase or sell crypto (i.e., “buying on margin” or “short sales” of crypto, respectively) implicates the retail commodity transaction analysis. (For more information on this aspect of the retail commodity transaction definition, please our 2016 posting Making Sense of the CFTC’s Enforcement Order and Settlement with Bitfinex.)

The CFTC’s enforcement division appears to be of the view that indebtedness in the traditional sense (i.e., the use of borrowed money) is not required in order for a transaction to constitute a retail commodity transaction, based upon a recent enforcement action filed by the CFTC in the U.S. District Court for the District of Columbia (CFTC v. 1Pool Ltd. and Patrick Brunner, Case 1:18-cv-2243, filed Sept. 27, 2018 (“1Pool Ltd.”) . In particular, 1Pool Ltd. involved a particular type of derivative known as a “contract for differences” or “CFD,” which the CFTC defined in that action as “[A]n agreement to exchange the difference in value of an underlying asset between the time at which the CFD trading position…is established and the time at which it is terminated.” Paragraph 25 of 1Pool Ltd.

The case did not make any mention of any sort of loan, borrowing, or other debt-based financing arrangement, so it is reasonable to assume that the economic leverage involved in many derivatives is a type of “leverage” for purposes of the retail commodity transaction definition. Further to this point, the 1Pool Ltd. enforcement action defined “margin” in the context of CFDs as the amount of bitcoin deposited by a customer with a platform as collateral, while “leverage” was said to allow a customer to: 1) “control a large amount of commodity with a comparatively small amount of bitcoin”; and 2) “significantly boost their profits with a relatively small investment while also magnifying their losses.” Paragraph 30 of 1Pool Ltd. According to the complaint filed by the CFTC, the CFDs at issue in 1 Pool Ltd. contained “margin with leverages as high as 1/200 depending on the underlying asset.” Paragraph 29 of 1 Pool Ltd.

Interestingly, the Securities and Exchange Commission filed a parallel action against the same defendant in which it characterized CFDs as security-based swaps. As a matter of statutory construction, a security-based swap is a “type” of a swap, which further supports the understanding that CFDs appear to be swaps and retail commodity transactions.

Swaps and Retail Commodity Transctions: So, What’s the Point?

As we explained in Part 4 of current series of posts on considerations for investment funds and advisers related to cryptocurrency derivatives, the CEA and related CFTC regulations require a market participant that does not qualify as an “eligible contract participant” (or a “non-ECP”) to enter into commodity interests through a regulated intermediary (i.e., a futures commission merchant) and over a regulated exchange (i.e., a futures exchange).
We refer to this requirement as reflecting a bedrock principle of “mandatory intermediation,” and note that this is only one of several aspects of the regulation under U.S. commodity laws that reflects this principle.

Applying this principle to CFDs, a significant consideration appears to be whether the CFD was offered to a retail participant without the involvement of regulated exchanges or regulated intermediaries (i.e., on a principal-to-principal or “over-the-counter” basis). If so, the CFTC seems to be in a position whereby it could characterize a CFD as an unlawful off-exchange swap, an unlawful off-exchange retail commodity transaction, or both.

Applying this principle to financial transactions more broadly, it raises the question as to when and under what circumstances a transaction may be a retail commodity transaction or swap, or exempt from regulation as either or both types of commodity interest. Is it the presence of “leverage, margin or financing”? If so, just exactly do those terms mean in respect of other types of agreements, contracts or transactions?

Perhaps market participants will know it when they see it…or perhaps it will only be apparent after the CFTC has identified it as being present. Whatever leverage or margin may be, the CFTC’s enforcement division appears to be of the view that it is present in a CFD for purposes of section 2(c)(2)(D) of the CEA.